About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
There is an apocryphal story about the inquest of the sinking of the Titanic. When the Titanic’s captain was asked why he did not swerve to avoid the iceberg, he replied, “What iceberg?”
Judging by Federal Reserve Chair Jerome Powell’s silence about the warning signs of crises in the world’s three largest sovereign-bond markets, one has to wonder whether something similar might soon be said of him at the inquest of a future financial-market crisis. When he is asked why the Fed did not pivot away from its aggressive monetary-policy stance of interest-rate increases and quantitative tightening in the face of the looming sovereign-debt crises, he might reply, “What debt crises?”
The truth of the matter is that for different reasons we could have debt crises as early as this summer in the world’s three largest sovereign bond markets: the United States, Japan, and Italy. Should any of these crises occur, they could shake up currently illiquid world financial markets. They could do so in much the same way as the recent UK gilt-market meltdown in the wake of former Prime Minister Liz Truss’s ill-advised budget shook up UK financial markets.
By far the most worrying of the potential debt crises is that in the United States. That is not simply because the US has by far the largest government-debt market. It is also because the US debt market serves as the risk-free rate by which other interest rates are set around the world. A spike in the ten-year US Treasury bond rate would reverberate around the global economy.
The reason to fear a US sovereign debt crisis this summer is the ongoing showdown over raising the debt ceiling. In a letter to House Speaker Kevin McCarthy, Secretary Treasury Janet Yellen indicated that the US government reached its debt ceiling on Thursday. She also indicated that the Treasury is now taking “extraordinary measures” that should allow the government to avoid a debt default at least until early June.
Making a protracted debt ceiling fight all the more likely is the large gap between the Republican House Majority and the Biden administration’s opening positions on this issue. McCarthy, who is beholden to the Republican Party’s Freedom Caucus, keeps repeating that he will not agree to raise the debt ceiling without a commitment to large public spending cuts, including Social Security and Medicare spending. For his part, Biden believes that the debt ceiling should be raised without any conditions attached since Congress already approved the underlying spending.
As we should have learned from the 2011 US debt ceiling battle, financial markets can become highly unsettled if the debt negotiations go down to the wire. That was the case in 2011 even though in the end a debt default was avoided. Needless to add, if the US were to actually default, all hell would break loose in world financial markets as the creditworthiness of the world’s largest government debtor was placed in question.
The reason to fear a Japanese sovereign-debt crisis is the recent pick-up in that country’s core inflation rate to 4%. A new head of the Bank of Japan is likely to take office in April. A crisis could come soon after. Inflation could force the BOJ to abandon its current policy of yield-curve control. That in turn could lead to a sharp spike in long-term Japanese government bond yields. As recently occurred in the United Kingdom, any unexpected spike in government bond yields could catch major Japanese financial institutions offside.
As if this weren’t enough to keep central bankers awake at night, there is also the real risk of another round of the European sovereign debt-crisis unfolding later this year. It would be centered on Italy, which has the world’s third-largest sovereign bond market.
Until now the European Central Bank has kept the highly indebted Italian government afloat by buying the entirety of that country’s net government bond issuance under its quantitative easing policy. However, the ECB has announced that beginning in March it will start a policy of quantitative tightening at the pace of 15 billion euros ($16 billion) a month. This has to raise the question as to who will be financing the Italian government’s gross borrowing needs of more than $250 billion this year and at what interest rate?
Even before a sovereign-debt crisis occurs, rapidly declining US inflation and a slowing in the US economy would have justified a pause in Fed interest rate increases and a scaling back in the pace of quantitative tightening. Now that there is good reason to fear a sovereign-debt crisis soon in at least one of the major debtor nations, there would seem to be all the more reason for the Fed to pause if it is to avoid monetary-policy overkill.
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